Checking liquidity and watching style drift could prove a bit more challenging this year as you try to rebalance in the most tax-efficient manner.
With traditional mutual funds expected to report billions of dollars in capital gains at year's end, investors face a double whammy.
Besides being forced to pay more in taxes, stock funds are producing double-digit losses in 2008. The broad Vanguard Total Stock Market ETF (NYSE: VTI) is down more than 38% so far.
As a result, these are times when the advantages of exchange-traded funds and index mutual funds tend to move to the forefront. The unique creation and redemption process of ETFs, in particular, usually make them a more tax-efficient investment in terms of limiting or even eliminating the burden of capital gains distributions.
But perhaps one of the most neglected tools of ETFs and index mutual funds is their flexibility in tax-loss harvesting. Most don't churn their portfolios much, making them ideal for taxable accounts. That can have drawbacks, though.
Take for example if you'd invested in a fund that tracked the blue chip S&P 500 Index. The granddaddy of the group is the Vanguard 500 Index Fund (VFINX). It has been around for more than 32 years. If you'd been fortunate enough to have bought the index mutual fund when it launched on Aug. 31, 1976, you'd be sitting on a nearly 2,075% cumulative gain.
If you started with $10,000 in the fund, that means an investor making no other contributions would be sitting on about $207,500 in gains. And that includes the 38%+ drubbing that VFINX has taken so far this year.
But you can turn such short-term losses into a positive, through exercising Internal Revenue Service provisions allowing a certain amount of tax-loss harvesting.
"In a year like this, almost nobody should be paying any taxes. At a minimum, you should be making sure to eliminate any capital gains liabilities for 2008. That means looking at accounts and making sure you're not in any net positive gains positions," said J.D. Steinhilber, a Nashville, Tenn.-based advisor.
The best-performing ETF in the past three years has been the iShares FTSE/Xinhua China 25 Index (NYSE: FXI). It was averaging annualized total returns of 14.22% through Tuesday. That means you'd have made a cumulative 49% gain over that period and $4,900 in profits on a one-time $10,000 investment.
Now, consider that FXI is down more than 48% this year. You could sell your entire position, or part of it, book those losses in 2008, then repurchase the ETF in 31 days.
So how much can you deduct from your taxes? The first step is to compare short-term gains against short-term losses. Then you need to compare long-term gains to long-term losses. If adding those net totals together results in a negative number, you can use up to $3,000 of those losses to offset ordinary income. And in many cases, you can carry over extra losses to subsequent years.
But that's a rather general summary. Before making any moves, at the very least you should check the step-by-step explanation of the process given on IRS Form 1040's Schedule D. It can be found on the Internet here).
"One of the most important aspects of tax-loss harvesting is its role in reducing the tax costs of rebalancing, which is critical for managing portfolio risk," said Richard Shaw, an advisor at QVM Group in South Glastonbury, Conn.
But to keep your intended exposure to the market, it's important to make as accurate of a substitute for the fund being replaced as possible.